Passive vs active investing: Which is more profitable? [Crypto indexing part 1]
A passive investor does not try to beat the market, instead, he invests in vehicles like index funds and ETFs tracking the SP500. An active investor, by contrast, tries to outsmart the market by making active bets such as trying to pick the right stock. These bets make it possible for an active investor to perform better or worse than the market.
The last 20 years a strong trend has emerged within the financial markets — passive investing is on the rise. In 2017 the net inflow from active funds to passive index funds was USD 500 billion, as shown in the figure.
There are good reasons for investors to put their money into passive vehicles. Academic studies have shown that trying to beat the market is an unprofitable strategy. For an overview of the literature see for example Fama’s paper “Efficient Capital Markets” published in the Journal of Finance, 1969. To understand why passive investing beats active, consider the following sequential logical argumentation, written in the form of three statements:
- Active managers cannot collectively beat the market.
- Sub-groups of active investors do not beat their index.
- Top performers do not stay top performers.
The first statement is just plain arithmetic and was proved by Sharpe in his article “The Arithmetic of Active Management” published in the Financial Analysts Journal, 1991. Some active managers must have returns higher the market, and some must have returns lower than the market. As a collective, they will have a return equal to the market. After including fees, however, the collective of active investors will be beaten by the market due to trading costs.
The second statement is proved by empirical studies. Active managers investing in a certain style (e.g. stocks with high dividend yield or small-cap growth stocks) do not beat their sub-index. This makes intuitive sense because almost any style can be replicated with an index, and since indices are less costly than portfolio managers an investor can get the same return for a lower fee.
The last line of defence for active investing is that whilst the two previous statements are true, there exist people who can make the right judgment call and beat the market consistently. Data suggests the opposite. Every year, some investors do indeed beat the market, but these investors are different persons from year to year. By ranking the portfolio managers in one period, and then studying how they performed in subsequent periods, it is evident that the top performers do not stay top performers. This is logical since risk-taking can give extreme returns — sometimes extremely positive and sometimes extremely negative.
The performance of active money managers provides the best evidence yet that indexing may be the best strategy for many investors.
/ A. Damodaran, Professor of Finance at NYU.
More content from the author
Read the next article in this series: Correlations create diversification.
Jacob Lindberg, the author of this post, is the founder & CEO of Vinter — an index provider and data analysis firm specialized in cryptocurrencies.
